Friday, December 30, 2011

Ron Paul was responsible for publishing a variety of newsletters over a long period of time. Between 1989 and 1995, the newsletters included some hateful, racist remarks. There were also ugly remarks regarding gay people.

Ron Paul has said that he didn't write those remarks.

I believe him.

Ron Paul has said that he wasn't aware of the remarks until they were used to attack him in his 1996 campaign for Congress.

I believe him.

Paul served in Congress from 1976 to 1986, failed to get the Republican U.S. Senate nomination in 1986, and then ran for President as the Libertarian Party nominee in 1988. He returned to practicing medicine full time from 1989 to 1996. He returned to Congress again in 1996, and it was during the campaign when he first learned of some of the things that he had supposedly written over the previous several years.

More importantly, Paul disavows the remarks in the newsletters.

Paul's basic political philosophy is libertarian--he believes that all individuals, regardless of ethnic background or sexual preference, have equal individual rights. A racist politics, based upon defending the white race, or focused upon threats to society from African-Americans, Latinos, or Jews, is foreign to his thinking.

Most importantly, Ron Paul is a nice guy who is not comfortable saying or writing rude, ugly, or insulting things.

In my view, his primary political concern has always been inflation, which he believes results from money creation by the Federal Reserve. He believes the result will be economic collapse--a terrible inflationary depression. In his view, the solution is a gold standard. As a practical matter, the emphasis of his politics has been opposing all the activities of the Federal government inconsistent with the very strict limits that follow from his interpretation of the U.S. Constitution. That includes most of U.S. foreign policy today. In his view, the U.S. Constitution solely gives the federal government authority to defend the U.S. There is no constitutional authority for projecting military power to promote the economic interests of U.S. business overseas or even the humanitarian values expressed by voters.

Paul's core views tie together, because the U.S. cannot afford all of this unconstitutional activity, which is what leads the Federal Reserve to print money to finance deficits, which will result in economic disaster in the long run. In Paul's view, the long run is just about here.

So, what about the newsletters?

All of the newsletters were written as if they came from the pen of Ron Paul himself. They didn't. They were ghostwritten. How were these ghostwriters selected? Why didn't Ron Paul review their work?

The best evidence that we have today is that Lew Rockwell was in charge of the newsletters. Who is Rockwell? He was Paul's Congressional Chief of Staff in the seventies. He was a vice-President of Ron Paul Enterprises when the newsletters were written. He was President and then CEO of the Mises Institute.

Rockwell has been accused of penning the offensive passages himself, a charge he denies. I believe him. Rockwell has stated that there were seven or eight ghostwriters for the Ron Paul Newsletters. The most likely scenario is that one, or perhaps several, of these unnamed ghostwriters were directly responsible.

However, I don't believe that there is some rogue ghostwriter that can be singled out. Again, the most likely scenario is that this sort of over-the-top propaganda and nasty invective was exactly what the ghostwriters were asked to provide by Rockwell, and mostly probably, by Murray Rothbard.

During this period, Rockwell was working very closely with Rothbard. Rothbard was a radical libertarian economist and a student of Austrian economist Ludwig Von Mises. Mises hated inflation and strongly supported the gold standard. It is the connection to Mises, along with Rothbard's own uncompromising support for the gold standard, that tied him to Paul.

With the fall of the Berlin Wall in 1989, Rothbard thought that the right wing could be weaned away from foreign intervention. While Rothbard was never much worried about the communist threat and favored deep cuts in defense spending during the sixties and seventies, he hoped that with the dissolution of the Soviet Union in 1991, conservatives could be convinced that a smaller military establishment would be possible.

Second, after the ATF stormed David Koresh's compound in Waco, Texas in 1993, "the militia movement," developed. Conspiracy-minded right wingers were training with assault rifles all over the U.S. Many were concerned that the Clinton administration was going to seize all of their guns. They were devoted to the U.S. Constitution, especially the second amendment.

Third, in Europe, the Progress Party in Norway began to grow by opposing immigration. It received 23% of the vote in 1988 (compared to Paul's .5% for President as a Libertarian.) In 1993, the "libertarian" wing of the party dropped the anti-immigrant focus and political support dropped to 6.3%. The Freedom Party in Austria had been a moderate classical liberal party, like the German Free Democrat party. Under Jorg Haider's leadership, starting in 1989, they began to focus on opposition to immigration. In 1993, they began their anti-immigrant, Austria first, petition drive. They become a major player in Austrian politics. (Haider also created controversy by saying that the Nazi employment policy was better than that of the current government. Haider was regularly accused of having pro-Nazi and anti-semitic views. )

This was the period in which Rothbard and Rockwell developed "paleo-libertarianism." In my view, the newsletters were aimed at appealing to the militia movement, with the goal of turning it into a libertarian movement along the lines of the Progress Party or Freedom Party in Europe, that was strongly anti-foreign intervention, anti-Federal Reserve, and pro-gold.

The rhetorical approach in the newsletters, particularly the ugly invective, was Rothbard's way. Rockwell has a similar rhetorical approach. While Rothbard may have been one of the ghost writers cited by Rockwell, perhaps not. The ghostwriters, presumably other "Rothbardians," (libertarian who continued to follow Rothbard wherever he led,) were writing a message in the newsletters consistent with both the strategy and style of Rothbard and Rockwell.

Most libertarians rejected Rothbard and Rockwell's "paleo-turn." Libertarian economist Steve Horwitz gives his view here. To this day, some of the ugliest invective coming from Rockwell and the remaining paleo-Rothbardians is aimed at the libertarians who refused to follow along.

Ron Paul always stayed above these squabbles, but he let Rothbard and Rockwell use his name. Why?

I think the primary reason is that Rothbard and Rockwell share Paul's strong support for the gold standard and opposition to the Federal Reserve. While many libertarians agree, plenty do not. Further, Ron Paul is extremely pro-life. Rockwell agrees. Most libertarians are pro-choice. While Rothbard, last I knew, took an extreme pro-choice position on abortion, he and the other pro-choice paleo-Rothbardians didn't and don't fight Paul on the matter. Finally, there is the shared opposition to an interventionist foreign policy. While many libertarians agree, plenty do not.

In short, Paul trusted Rockwell and Rothbard to develop a strategy that would help promote individual liberty and limited government. Clearly, he knew the general outlines of their strategy. It was hardly a secret plan. Rothbard and Rockwell both wrote public manifestos in their attempts to bring other libertarians on board.

It came to an end in 1996. What happened?

Todd Seavey suggests that the Oklahoma City Bomber might have had something to do with a softening of tone. Suddenly, appealing to the conspiracy-minded militia movement began too look a bit risky. Seavey also points out that it was the year Rothbard died. A bright and articulate advocate of the approach was no longer there. (On the other hand, who knows what strategic coalition Rothbard would be promoting today.)

But I think it is simple. Ron Paul found out that rude and ugly words were being put into his mouth. "He" was trashing figures whom, on the whole, he admired, like Martin Luther King. Worse, he was supposedly making childish insults of people he had worked with personally, like Barbara Jordan. He put a stop to it.

Some have accused Paul of publishing the newsletters for the money. When challenged by a reporter that he made $1,000,000 in a single year, he seemed surprised. He explained that during that time he was practicing medicine full time to make a living. In other words, he wasn't making so much money as a newsletter publisher that he could retire, and he was busy with his "real job" which might be why he didn't pay much attention to what Rockwell was doing with the newsletter. Rothbard had a position at the University of Nevada at Las Vegas. Rockwell, on the other hand, may have needed to earn an income, and the ghostwriters may well have been writing this stuff "for the money."

Perhaps some of the money ended up endowing the Mises Institute. Still, I think they were writing material that they thought would appeal to rightwingers, trying to turn them away from foreign intervention and towards limited government.

In 1996, when the newsletters were used against him in his campaign for Congress, Paul didn't say that he didn't write the passages nor did he disavow them. Why? He says that his campaign aides argued that his name was on them, and so he was responsible. Trying the explain them would be "too confusing." (His efforts to defend them looked a bit weak to me.)

As far as I know, no one asked him point blank if he really wrote the material and so, he just deflected the questions as best he could. It is also possible that some of those "aides" still thought that those words that were put into his mouth would help with his political career. It could be nothing more than the political contributions they were getting by using the old mailing list, but perhaps they still thought that a U.S. version of the Progress Party was in the cards.

To this day, there are supporters of Ron Paul who will argue that there was nothing wrong with anything in the newsletters. Thankfully, Ron Paul disagrees. Ron Paul is not a racist. He has no use for any kind of racist politics. And, he is a nice guy who doesn't say rude and ugly things about anyone.

Here is a very good paper by Mankiw and Ball on budget deficits and the national debt.

The basics are great. Their conclusion is that budget deficits help current taxpayers and future capital owners while hurting future taxpayers and future workers. (For those of us who consider much of current government spending as a waste, and consider cutting that spending an option, the "benefits" to current taxpayers are largely an illusion.)

They also consider the "unlikely" possibility of a fiscal crisis--a sudden loss of confidence in the willingness of the government to pay its debts. This analysis is good as well, though they fail to consider an optimal monetary policy (nominal GDP targeting, of course.) Recent events in Europe are following the script they outlined in 1993 to a remarkable degree.

They express hope that developed country central banks would avoid inflation despite the fiscal crisis. I suppose this is what the European Central Bank is doing. With nominal GDP targeting, a loss of confidence in government debt would be inflationary in two ways. Most importantly, the drop in the exchange rate directly raises import prices, and unlike CPI targeting, import prices play no direct role in nominal GDP. Only as higher import prices (and exports) impact the demand for current output does nominal GDP tend to rise, requiring more restrictive monetary conditions to limit that growth to the target growth path. However, there is a limit to inflation from that source, with the prices of consumer goods rising to a higher level (or growth path) rather than growing at a permanently faster rate.

The other inflationary impact is due to changes in productive capacity. These have two elements, both discussed by Mankiw and Ball. The first is a shift from nontraded goods to traded goods. In other words, an expansion in the production of import-competing goods and exports. In the U.S. today that would be fewer restaurants and yoga lessons and more domestically produced cars and machine tools to be sent to China. Because these shifts take time, production and employment will be depressed. This is a temporary reduction in the productive capacity of the economy which with nominal GDP targeting results in a higher price level.

The second effect is more long run. The capital stock shifts to a lower growth path along with the productive capacity of the economy. This will also raise the price level with nominal GDP targeting.

These two factors imply a shift of the price level to a higher growth path. With a 3 percent growth rate for nominal GDP, the result is temporary inflation, with the inflation rate returning to approximately zero, but at a higher level. With a 5 percent growth rate for nominal GDP, inflation would accelerate for a time, but then return to the 2 percent trend.

Mankiw and Ball also discuss the possibility of a more general financial crisis. The real effects described above could result in bankruptcies for various firms and eventually result in bank failures. While they don't say much about it, they hint at Bernanke's view that it is a disruption of productivity enhancing financial intermediation that results in Depression. While I have my doubts about that, having the banking system closed down, or at least in the process of reorganization, would have some adverse impact on productive capacity too. (Figuring out a way to rapidly reorganize banks, with an emphasis on debt-equity swaps needs to be on the front burner.)

Interestingly, these impacts on the price level and inflation are harmful to foreign creditors. A nominal GDP target, therefore, may limit the ability of a government to borrow in the first place, (and shift more of the impact to capital accumulation.) While that is not necessarily a bad thing, a shift to nominal GDP targeting in the midst of a crisis might exacerbate capital flight.

Of course, the U.S. does not currently have a problem with "capital flight." Still, I wonder to what degree keeping Chinese (and other foreign) creditors happy prevents the Federal Reserve and the rest of the Federal government from implementing nominal GDP targeting.

P.S. Mankiw and Ball are mainstream, new Keynesian, neo-classical economists. What, if anything, do my Austrian friends find wrong with their analysis of deficits and debt?

Thursday, December 29, 2011

Nick Rowe gives an explanation of why government debt imposes a burden on future generations. He even mentions James Buchanan. Rowe's argument is one of his all apple consumption economies. Still, I think I agree with his argument.

My view, which follows one of Buchanan's simple formulations is that financing government consumption spending by debt allows the current generation to receive the services from public goods at a lower tax price.

While those buying the government debt give up private goods and services (to provide the resources to needed to produce the public goods,) they receive government bonds in exchange and are no worse off. They can receive the principal back in the future, along with interest.

If they had not purchased the government bonds, they could have instead purchased capital goods, either directly or else equity or debt claims. These capital goods would have increased future output, and provided a stream of future income. Further, if the capital goods are not replaced when they wear out, that provides additional consumer goods to pay back the principal.

When they instead purchase the government debt, the stream of income and principle payments come from future taxpayers. Either future taxes are higher than they otherwise would be, and future taxpayers have fewer private goods and services than they otherwise would have, or else, the government pays interest out of given tax revenues and provides fewer public goods in the future than otherwise. Those in the future receive fewer services from public goods than they otherwise would have.

Obviously, this argument is an alternative framing of crowding out of investment and so reduced future production. To me, that only means that one should be careful not to try to make the arguments additive.

Rowe makes the argument without public goods (it is a straight transfer) and without capital goods (it is all consumption loans.) Assuming the interest rate is greater than the rate of growth of the economy, Rowe argues, future taxpayers must give up consumption to pay off the loans, and are worse off. As in the more complicated version I described, the loss to the taxpayers is not offset by the payment bondholders, who are being compensated for the consumer goods they gave up when they purchased the bonds.

Rowe argues that if the interest rate is less than the growth rate of the economy, this no longer holds. Then it is possible to fund government spending by debt without there being any burden on future taxpayers.

In my view, that isn't exactly correct. Interest expense is part of the future budget, and taxes are higher than they otherwise would be, or the provision of public services are less than they would otherwise be. With a growing economy, some of the benefits of future growth are transferred from the future to the present. From my perspective, rather than future generations being able to enjoy lower tax rates because essential government services can be provided with a lower fraction of growing incomes, they must pay interest on past debts.

But Rowe's framing is that the government runs a deficit today to provide public goods (or transfers in his example) and then runs deficits in the future to fund the interest payments on the national debt. If the interest rate on the national debt is less than the growth rate of the economy, the national debt shrinks relative to income. As the centuries pass, the burden of the national debt becomes smaller and smaller. In the year 10,000, perhaps a philanthropist could pay it off with spare change. Of course, that is a burden--just very small. But in that scenario, it never need be paid off.

If this is true, and the interest rate is less than the growth rate of the economy, then why have taxes? Why not provide public goods until their marginal value is zero? Well, presumably private consumer goods and services would still have value, so why not transfers? Apparently, the government should run a deficit and create a national debt high enough that the interest rate is equal to the growth rate of the economy. Outside of Rowe's apple world, this would presumable work at both margins--raising the interest rate and reducing the growth rate of the economy.

What troubles me most about these sorts of thought experiments is that they assume perfect knowledge about the indefinite future. For example, suppose the government can borrow today at a rate that is lower than the growth rate of the economy. We decide to take advantage of the free lunch. What happens if the economy grows more slowly or the interest rate rises? For example, suppose the population begins to decline in the U.S., while great investment opportunities in China pull up interest rates? Maybe those future generations should impose capital controls and outlaw birth control?

Some time ago, I endorsed Gary Johnson for President. Johnson is no longer seeking the Republican nomination for President and is now seeking the Libertarian nomination for President. I hope Johnson is able to win the Libertarian Party nomination.

As for the Republican nomination, I now support my second choice--Ron Paul. My former third choice, Jon Huntsman, now moves to the number 2 position. The South Carolina primary is coming up fast!

While Ron Paul's foreign policy views are more dovish than my own, unlike most of the other Republican candidates this year, he is pointing in the right direction. The U.S. should have withdrawn from Afghanistan (and Iraq) years ago, and war with Iran would be an expensive mistake.

Paul is calling for cuts in the level of federal government spending. I agree that the U.S. government spends way too much. While I don't think $1 trillion cuts in one year are realistic, the rapid increase in government spending and deficits in the Bush and Obama administrations makes these heavy cuts consistent with my usual rule of thumb. Cutting net federal outlays to what they were at the beginning of the Obama administration (2008,) is a $600 billion cut. Ron Paul's $1 trillion returns spending to where it was in 2006, and still leaves a $300 billion deficit (given 2011 receipts.)

For the most part, I agree with Paul's views on personal liberties issues. For example, like Paul, I think Drug Prohibition is a mistake, for much the same reasons that Alcohol Prohibition was a mistake.

Why was Gary Johnson my first choice? I think his political resume as two-term governor is better than Paul's political resume as U.S. Congress back-bencher. On a more personal note, I think Johnson's resume as entrepreneur and mountain climber is great, but in a very different way, so is Paul's background as a medical doctor and family man.

Like Gary Johnson, I describe myself as "pro-choice" on abortion. In truth, I think government should not restrict early term abortions but that it should restrict late term abortions. Paul is strongly pro-life and favors having government outlaw all abortions. Worse, he emphasizes that issue and has sent glossy brochures to my house (and I presume to thousands of other South Carolinians who have voted in past Republican primaries) emphasizing his opposition to all abortions. It is clearly very important to him. Paul, however, does believe that any government suppression of abortion should take place at the state level. So, he opposes having the Federal government outlaw abortions in states that allow the practice.

Like Gary Johnson, I believe that the U.S. should allow more foreigners to come work in the U.S. (I even liked Gringrich's statement in opposition to deporting illegal immigrants who have been in the U.S. for years.) I think Ron Paul agrees. Like Ron Paul, I don't think the U.S. taxpayers should be forced to provide social services to immigrants. I even oppose "birth right citizenship." In 2008, I was a contributor and volunteer for Ron Paul. Like other South Carolina voters, I received glossy brochures on the immigration issue in the weeks leading up to the election. I didn't like what I saw. Ron Paul did get my vote.

What about monetary policy? As far as I can tell, neither Johnson nor Paul (nor any other Republican candidate nor Obama) have much to offer. I support Paul's proposal to audit the Fed. I support Paul's effort to protect the right of citizens to use alternative monies. (This is the core Hayekian monetary reform.) I even support ending the Fed. However, given our current level of economic knowledge, I would favor replacing it with a monetary authority that I suspect Paul would consider no better than the status quo. Still, I think the Federal Reserve, as an institution, just struck out. Strike one--Great Depression. Strike two--Great Inflation. And now, strike three--Great Recession.

Paul has been able to raise lots of money. He nearly won the Iowa straw poll and has a good chance at the Iowa caucuses. He is doing great! While I like Johnson better, most voters apparently disagree. I have met Ron Paul and he is a good guy. I hope that other South Carolinians will join me in voting for him on January 21st.

Thursday, December 22, 2011

Ben Bernanke and Michael Woodford wrote “Inflation Forecasts and Monetary Policy” in 1997. The thrust of their paper is a critique of having the central bank “target the forecast.” Most market monetarists have adopted Scott Sumner's insistence that the Fed target the forecast. Sumner credits this view to Svennson.

Bernanke and Woodford describe a scenario where the central bank targets the consensus of private forecasters, which comes right out of Hall and Mankiw’s 1994 paper, “Nominal Income Targeting.” However, they cite Dowd (1994) and Sumner (1995) which propose pegging the price of a CPI futures contract. Interestingly, Bernanke and Woodford have little complaint with Svensson’s (1997) proposal.

They see his proposal as:

“the central bank’s internal forecast is prepared with the use of a structural model, but that the model and data on the current state of the economy are used to determine the policy action, that according to the model, should result in a forecast equal to the target.”

And what of private sector forecasts? They also write:

“a central bank can choose a policy that has the effect of keeping private inflation forecasts equal to the targeting without having the form of a “forecast targeting” rule, and it is desirable that it do so.”

Incredibly, they even believe that the central bank can use the private sector’s forecast of inflation shocks and potential output shocks to plug into their structural model, and so keep the private sector’s expectation of inflation on target (pp. 681-2.) They describe this in the context where the private sector is mistaken so that the central bank is sacrificing that element of inflation stabilization that it could provide by ignoring the private sector’s forecast and just using its own better estimate of inflation and potential output shocks.

They go on to explain (p.682):

“A version of the proposal might reduce the extent to which the central bank is required to stabilize incorrect private forecasts rather than inflation would be to simply require the central bank to give public testimony about the motivation of its policy stance, that might well include discussion of its own inflation forecast. Private sector forecasts that disagree with that of the central bank might well be matters that would require comment on the part of the central bank, but one could accept an explanation on the part of the central bank of how its own forecasts are made as sufficient demonstration of a good faith effort to achieve the inflation target.”

The Federal Reserve doesn’t exactly target inflation, but rather inflation and unemployment. After its most recent meeting, the Fed gave its internal forecasts of both, and explained that both would remain below target for an extended period of time. Perhaps Bernanke should review what he wrote four years ago.

Like most market monetarists, I reject inflation and unemployment targeting and instead favor targeting the growth path of nominal GDP. Replacing inflation with the target for nominal GDP, what Bernanke and Woodford wrote would be appropriate. The Fed should set policy instruments so that its internal forecast is on target. However, it should also be just a little bit less arrogant than Bernanke and Woodford imagine, and be willing to make some adjustments based upon what the “wrong” private forecasts suggest.

Is it really true that if the private forecasters plug in their values for inflation and potential output shocks into a “true” model of inflation and report that, the result is that the eigen value is within the unit circle and the inflation rate is indeterminate? (p.671)? I don’t think so.

The fundamental problem with Bernanke and Woodford’s approach is that they assume that all forecasters have one true model and true information. If so, the central bank should just pay one of the forecasters for this information. Or why not hire one of them in place of their current staff?

The reality is that no one, not the central bank’s internal forecasters or any of the private forecasters knows the true model or has all of the needed information. They disagree. The goal should be to somehow combine both the central bank’s own forecast with those of the private forecasters to generate a market expectation that can be utilized to adjust current market conditions such that the market expectation is that nominal GDP will be on a slow, steady growth path.

Saturday, December 17, 2011

In 1994, Robert Hall and Greg Mankiw wrote a paper on "Nominal Income Targeting."

They advocate what Svensson would call a "target rule" for nominal GDP and propose that the Fed look at the consensus private forecast for nominal GDP either four quarters or eight quarters in the future and adjust current monetary conditions to keep the forecast on target. They do not favor an "instrument rule," that would specify a formula relating a policy interest rate or base money to nominal GDP.

They consider a rule for the growth rate of nominal GDP, a growth path of nominal GDP, and a "hybrid rule," that adjusts the target growth rate of nominal GDP according to deviations of real GDP from potential. They run simulations using a simple phillips curve model. They use errors from the actual consensus forecast to estimate the errors that would be generated by the alternative policy. They use the inflation shocks actually observed and assumed those same shocks would apply to the new regime. They simulate the period of the seventies and the eighties. The trend growth rate of nominal GDP is 2.5%.

They find that the growth path policy performs better than the growth rate rule both in avoiding variation in the price level and real output. However, real output is less stable that the actual performance. Since the period is the seventies and the eighties, this is very troubling. The hybrid policy--for example, raising the growth rate of nominal GDP when real GDP is below potential, did better with output stability.

They note that some of the errors in the consensus forecast involved errors in forecasting monetary policy. For example, the consensus forecast didn't predict the Volcker disinflation. If there had never been the Great Inflation of the seventies, there would have never been a Volcker disinflation. They also ran the simulation on the assumption that the forecasts were perfect, and the variance of real output relative to potential was better than actual performance.

Still, part of the reason for the output variance was the response to "supply shocks." The way they describe it, an inflation shock must be reversed within one year. Their simulation shows a deep recession in the early eighties. To the degree that this reflects the Volcker disinflation, it is an illusion. However, their model would generate a deep recession to reverse the inflation caused by the increase in oil prices during the Iranian revolution.

Their model is:

The change in the log of the price level is the trend inflation rate plus a term that shows the persistence of inflation plus a term that shows how the output gap impacts inflation plus the inflation shock term.

So, a supply shock this period just causes inflation this period. This forces nominal GDP above target, and then next period, this extra high inflation will continue to force prices up (the second term,) and based upon the consensus forecast, monetary policy must contract enough to force real GDP below potential enough to force prices down. Given their trend of 2.5 percent nominal GDP, deflation must be generated. Of course, the reduction of real GDP reduces nominal GDP directly and so the recession and deflation must combine to get nominal GDP back to target.

I see two problems with this model. First, there is no recognition that supply shocks combine a decrease in potential output with an increase in the price level. For example, if there is a bad harvest for corn, the supply of corn falls. The price of corn rises and the quantity of corn falls. The decrease in the quantity of corn is simultaneously a decrease in actual and potential output.

This just doesn't show up in the model at all. The increase in the price of corn would show up as inflation in the current period. That the production of corn falls, and that this is a decrease in both real output and potential output is left out. Assuming that the supply shock persists, both potential output and real output remain low and the price level remains high.

In the Hall and Mankiw model, potential output is basically the trend of real GDP. (.98 times its own lagged output plus .02 times current real GDP.) And so, the gap between real output and potential output is basically the deviation of real GDP from trend. That adverse supply shocks also reduce potential output is necessarily ignored, (well 98% ignored,) and overstates the actual deviation of real GDP from potential.

The second problem is the persistence of inflation. If the central bank will accommodate inflation, then it is certainly possible that higher inflation this period will cause people to expect more inflation and raise prices. However, with nominal GDP level targeting, particularly with a 2.5 percent growth path, there should be no persistence to inflation. In their model, inflation this period is partly reversed next period. More generally, if nominal GDP is above target and generates inflation, it will be reversed. A temporary adverse supply shock will be reversed. And a persistent adverse aggregate supply shock will raise the price level and leave it at the new, higher level.

A proper model of nominal GDP targeting will have the expected price level be equal to the target for nominal GDP divided by the expected level of potential output. Any deviation for the price level from that expected level should be expected to be reversed rather than continue to grow. Further shocks to that price level should have a negative covariance with shocks to both output and potential output.

However, Hall and Mankiw claim that only 2% of the volatility they find was due to these price shocks. Apparently, 98 percent was due to forecast errors. With nominal GDP targeting, that would imply a failure to hit the target.

Bernanke and Woodford in 1997 criticized using the consensus forecast for targeting. Under some circumstances such efforts to free ride on the consensus forecast results in indeterminacy. (However, using its own forecast but also considering outside forecasts is feasible.)

Bennett McCallum, also in 1997, proposed an "instrument rule" with feedback between the quantity of base money and nominal GDP. He ran simulations using both levels and growth rates of nominal GDP. His simulation found explosive results when an interest rate instrument was used to target the level of nominal GDP. This was less of a problem with base money targeting, though too large of a change in base money to a deviation of nominal GDP from its target growth path was explosive as well.

Targeting the growth rate of nominal GDP did not have explosive results whether interest rates or base money is used. Perhaps it is this potential for explosive results that has lead McCallum to favor targeting the growth rate rather than the growth path. McCallum also looked at a weighted average of the growth path and growth rate. It avoided explosive results too.

In my view, high frequency oscillations are very unrealistic. Perhaps it is because people don't respond mechanically to controls. Explosive oscillations require that past changes, especially for prices, be projected into the future, when in reality they will be reversed.

Still, even if large fluctuations in short interest rates or base money end up having little effect on nominal expenditure, much less prices or production, there would be little benefit in generating such changes. Targeting the forecast, as suggested by Hall and Mankiw, and allowing market participants to develop expectations that support the regime seems like a better approach that a mechanical feedback rule.

Suppose money expenditure on output falls. If prices and wages are both sticky, then firms sell less, produce less, and employ fewer workers. Real wages are unchanged. There is a surplus of output, but only in the sense that firms would like to sell more than they are currently producing and selling. There is also a surplus of labor. Households would like to work more than they are.

If money expenditure on output increases, then firms sell more, produce more, and employ more workers. Real wages remain unchanged. The surplus of output and the surplus of labor disappears.

If, on the other hand, money expenditures remain depressed, there is a market solution. The usual response to a surplus is a lower price. The surplus of labor leads to lower wages. As prices and wages fall together, real wages remain the same. However, if money expenditure on output remains the same, the lower prices result in higher real expenditures on output. Firms produce more and hire more labor. The lower money wages were essential to keep real wages from rising and depressing employment.

Note that real wages play no role in either process. Employment fell, and unemployment rose, without real wages changing at all, much less rising above equilibrium. Similarly, an expansion in the money supply increased output and employment without lowering real wages or impacting prices or wages at all. And finally, even if nominal expenditure remained lower, and both prices and wages fell in response to surpluses, employment recovers without any decrease in real wages.

So why is there a tradition of focusing on the real wage? In microeconomics, the demand for labor depends on the real wage. But then, everything in microeconomics is about relative prices, and that includes the relationship between the price of labor and the products of labor.

In macroeconomics, the reason for the focus on real wages is an assumption that wages are sticky and output prices are flexible. If nominal expenditure falls, then as explained above, the demand for output falls. As firms sell less, they lower prices. This raises real wages, and reduces the quantity of labor demanded and raises the quantity of labor supplied. The result, then, is a surplus of labor. Of course, the increase in real wage is also an increase in real costs, and so firms produce less. So, the result of the decrease in nominal expenditure is lower prices, lower output, lower employment, and higher real wages.

The market process that corrects the disequilibrium is lower money wages. This reduces real wages and real costs. The firms hire workers and produce more. To sell the extra output they lower prices. Given nominal expenditure, real expenditure rises. Firms can sell the additional output.

Market oriented economists have sometimes ridiculed the notion that increased nominal expenditure can raise employment. If workers will continue to work (and return to work) in the face of increase nominal expenditure, higher prices, and lower real wages, then why don't firms just cut money wages, reduce prices, and reduce real wages? It must be money illusion.

I don't pretend to have all the answers as to why money wages are sticky. However, the notion that reversing a decrease in nominal expenditure and a temporary decrease in output prices, would cause workers to do anything other than mourn the loss of the remarkable bargains they enjoyed for a time is absurd. That they would demand a nominal wage increase to permanently capture the transitory increase in real wages is possible, but not likely.

Free market economists, and especially Robert Higgs, have argued that "regime uncertainty" is reducing business investment. Higgs used the concept to tie the Roosevelt administration's populist rhetoric to low levels of investment during the Great Depression. Higgs has used the same concept to explain the Great Recession.

In my view, if the demand for investment falls, the natural interest rate falls as well. Assuming that the demand for money is less than perfectly interest inelastic, then the quantity of money needs to rise accommodate the increase in the demand to hold money. Nominal expenditure should continue on its previous growth path. The lower natural and market interest rate should dampen the decrease in the demand for capital goods and result in larger than usual increases in the demand for consumer goods. The resulting reallocation of resources may result in structural unemployment and slightly higher prices for a time. Worse, the slower expansion in the capital stock will result in more modest increases in labor productivity, and slower growth in real income. Given the growth path of spending on output, the result could be modest inflation.

If the reason for the decrease in investment demand was empty anti-capitalist rhetoric by politicians, then they should stop. If actual policies are causing the problem, then the economic costs should be weighed against whatever benefits these policies are supposed to generate.

However, some advocates of the free market have argued that an increase in the quantity of money and reduction in market interest rate are inappropriate. For example, Daniel Mitchel is here. Donald Boudreaux is here

In recent weeks, I have discussed the matter in comment threads on Free Banking and Uneasy Money. Comments were made (by the Liquidationist and RobR) suggesting that the "solution" to regime uncertainty was for money wages to fall. (I just found the Liquidationist's blog, here.)

The argument is that firms are accumulating money (and other short and safe financial assets) rather than hiring workers. The demand for labor is lower and the demand for money is higher. The solution is for nominal and real wages to fall enough, and for profits to rise enough, that the higher level of profits compensate firm owners for the higher perceived risk. Given this new distribution of income, firms will again be willing to hire labor, and employment will recover.

One rather obvious problem with the argument is that when the firms spend their accumulated money on hiring workers, wages will rise and profits will decrease, and higher profits no long compensate for the greater risk. However, presumably this sort of process could help explain why employment stops contracting. Lower wages, as well as the higher productivity of labor on the margin as more and more productive workers are let go, combine to make firms willing to bear the greater perceived risk rather than further reduce net revenue per worker by reducing employment further.

The process just doesn't generate recovery. If the nominal quantity of money is held fixed, then lower wages reduce costs, firms reduce prices, and real money balances rise. The conventional analysis is that those holding money balances purchase bonds, and this raises bond prices and reduces bond yields. The market interest rate falls. Real consumption and real investment expand, and as real expenditure rises in total, firms sell more, produce more, and hire more workers.

However, rather than buy bonds with increased real balances, firms might hire workers (and purchase other inputs) and produce output. But this is reducing difference between input and output prices--again reflecting the lower market interest rates.

If saving is perfectly inelastic with respect to the interest rate, then the real interest rate must fall enough so that investment, (including in the working capital firms use to hire workers and purchasing other inputs to produce output,) returns to its initial level. While the distribution of income between bond holders and stockholders might change, with bond holders receiving a lower return and the stockholders receiving higher gross returns and lower risk adjusted returns, real wages would not fall.

But if saving is not perfectly inelastic with respect to the interest rate, then the process results greater consumption. With more consumption and less investment, labor productivity and real wages will grow more slowly, and perhaps might fall.

Taken to the extreme, if saving is perfectly elastic with respect to the interest rate, then any reduction in investment demand, including one caused by "regime uncertainty," has no effect on the natural interest rate, but simply results in less investment and more consumption. Of course, with no decrease in the natural interest rate, there is no increase in money demand and no reduction in spending on output.

Still further, if we assume that the greater "regime uncertainly" applies to wealth accumulated by households, then the supply of saving might fall more than the demand for investment, resulting in a higher natural interest rate along with a shift in the allocation of output away from capital goods and towards consumer goods.

Presumably, firms producing consumer goods would initially be motivated to spend less on labor and other inputs because they insist on a higher interest return. However, the shift in demand from durable capital goods towards consumer goods will result in higher prices. Meanwhile, the firms selling capital goods will see a major contraction in their sales, freeing up "working capital" to use in consumer goods industries.

To sum up, if businessmen respond to "regime uncertainty" by demanding more money rather than purchasing capital goods (or even labor and other inputs for current production,) then this decrease in investment demand results in a lower natural interest rate. Generally, this requires an increase in the quantity of money to maintain nominal expenditure. The allocation of resources shifts from capital goods to consumer goods. If the quantity of money does not rise enough to maintain nominal expenditure, then lower prices and wages will cause real balances to increase and the interest rate to decrease, expanding real consumption and investment expenditure as above. The allocation of resources still shifts to consumer goods from capital goods.

If, on the other hand, businessmen and wealthy households respond to "regime uncertainty" by expanding consumption rather than shifting their asset portfolios to money or other safe assets, then the result is still a shift in the allocation of resources from the production of capital good towards consumer goods. There is no tendency for a decrease in nominal expenditure. There is no need to increase in the quantity of money and perhaps a reason to decrease it. The natural interest rate rises, and real wages will be depressed, or at least grow more slowly.

If "regime uncertainty" leads to an increase in the demand to hold money, then it will tend to depress money expenditures on output. An expansion in the quantity of money and lower market interest rates is exactly the proper response. The result will be the proper change in the allocation of resources. Insisting on "tight money," will simply make a bad situation worse.

While improving "regime certainty" in the sense of creating a better tax and regulatory framework for business would be helpful, it is more important to fix the monetary regime. That involves keeping nominal expenditure growing at a slow steady rate. To the degree greater "regime uncertainty" has been allowed to reduce nominal expenditure, returning it to the trend growth path is desirable and probably necessary for otherwise desirable "supply-side" reforms to be much help.

Stiglitz has been arguing that growing productivity in agriculture was responsible for the Great Depression. Similarly, he argues that growing productivity in manufacturing is responsible for the Great Recession. The demand for manufactured goods is inelastic, so those in the manufacturing sector have lower incomes. Supposedly, their lower income reduces demand in the rest of the economy. Aggregate demand falls, firms produce less, so output and employment are depressed.

Nick Rowe takes him to task for failing to see that income equals output. Growing productivity in some sector raises aggregate output and generates the additional income necessary to purchase the output. Rowe recognizes that people may not want to purchase the added output, but that is the source of the problem, not the added productivity. Rowe, then, accepts that an increase in aggregate income or a change in the distribution of income might lead to increased saving. That could reduce spending on output to the degree it results in an increase in the demand to hold money.

(Those defending Stiglitz focus on this argument--he is providing a reason why the natural interest rate might be low. If the natural rate is low enough, conventional monetary policy is ineffective and results in real expenditure less than potential output.)

Caplan has been arguing that Keynesians should be calling for wage cuts. In Caplan's view, lower wages will result in higher employment. He has been challenging the argument that the lower wages will result in lower wage income and reduced spending on output. He argues that if employment grows. while each full-time worker might earn less, there will be more workers to earn income. And further, if the demand for labor is not elastic, and labor income does not rise with greater employment, then profits expand and the expenditures of the owners of the firms generates greater expenditure.

Rowe takes Caplan to task as well. If output is limited by demand--what can be sold--the lower wages will not raise demand for output, and firms won't hire workers to produce more if they cannot sell any more output. Assuming greater employment will not do. And lower wage income and higher profit income, leaving aside quite plausible differences in saving and willingness to accumulate money, just changes who purchases the output.

In my view, Caplan's macroeconomic understanding is sound. He is assuming that wages are sticky and prices are flexible. If nominal expenditure on output falls a given amount and then stays constant, prices of output fall immediately. But wages don't fall. This raises real wages, and the profit maximizing level of output falls. Given that lower level of output, the price level falls enough to sell this reduced level of output, but less than in proportion to the drop in nominal expenditure. With constant money wages and a lower price level, real wages have risen. The firms employ less labor in a way that is perfectly consistent with the lower production. It is basic micro-profit maximization.

Now, when wages fall too, the real wages fall. Costs have fallen and firms produce more and lower their prices. Given nominal expenditure, this is an increase in real expenditure on output. The firms, in aggregate, can sell more. The expansion in production and employment is perfectly consistent with microeconomic principles. If wages fall enough, the new equilibrium is identical to the initial one in real terms. Nominal prices and nominal wages wages are both lower, but real wages, real output, and real income are all at the initial level.

Of course, this argument assumes that lower prices and wages don't cause reduced expenditure on output. In the end, it must be based on given quantity of money and some sort of stable demand to hold real money balances. And the elasticity of the demand for labor and added expenditure out of possibly greater profits are irrelevant.

So, what is up?

Consider a different scenario. All prices and wages are quite flexible, except one problem. There are price floors on all final output. Velocity is constant and the quantity of money is reduced. The equilibrium price level is lower, but prices can't fall. Production falls to match reduced demand for output.

Firms need less labor to produce less output. Employment falls. There are surpluses in labor markets, and so wages fall. Prices are fixed, and so this is a reduction in real wages.

The reduction in wages reduce costs and increases the surpluses in product markets. Firms would like to sell more, but because they cannot reduce prices, their actual sales and production remain at the lower depressed level.

Assuming the supply of labor has the usual positive slope, then once real wages are low enough, the quantity of labor supplied falls enough to match the lower quantity demanded. If the supply of labor is perfectly inelastic or worse, has a positive slope, then real wages would drop to zero. Of course, that is the region where Malthusian effects--starvation--will reduce population enough so that the quantity of labor supplied matches the demand. In other words, real wages turn perfectly elastic at subsistence in the long run.

However, there is another process at work that will tend to clear up the surplus of labor. As real wages fall, it becomes more profitable to utilize more labor intensive production methods. Even assuming output doesn't rise, it will become profitable to use more labor to produce it at lower real wages.

If the supply of labor is assumed to be perfectly inelastic, (workers need jobs,) then real wages fall to a level where the quantity of labor demanded matches quantity supplied. Less capital intensive production methods will be used. Labor productivity falls enough so that full employment of labor results from producing the demand-constrained level of output. (Hopefully, the market clears at wages higher than starvation levels.)

And with the workers having lower real wages, who will be buying this output? Well, if we compare the workers' demand for output at full employment with a lower real wage to what they demanded at less than full employment at a higher real wage, the reduction in total labor income will be less than in proportion to the decrease in the real wage. While the less inelastic labor demand, the smaller the decrease in labor income in aggregate, elastic, or even unit elastic labor demand is implausible. Of course, if labor's share of the fixed income falls, the owners of the firms will be earning more profits, and so they can consume more.

And so, what is the characteristics of the new equilibrium? Real and nominal output and income are at the reduced level. Still, there is full employment, because more labor intensive methods of production are used and because at lower real wages fewer people choose to work. It is very likely that the labor share of income is lower, and workers consume less. The capital share of income is higher, and business owners live in bigger mansions, have bigger yachts, and fancier limousines. And maybe more servants too.

To some degree, the old, more productive capital goods would be abandoned, but it is likely that to some degree they just aren't replaced. In other words, the initial drop in real wages will be greater, and only gradually, as production technologies are shifted to those with lower labor productivity, will the quantity of labor demanded rise. Once the capital stock has readjusted, then there will be no excess capacity. Potential output will have fallen to match the demand-constrained level of output.

I certainly don't accuse Caplan of advocating something like the above. In fact, he advocates raising the quantity of money enough to reverse any decrease in nominal expenditure on output so that there is no need to decrease nominal wages. And, as I explained above, if that doesn't occur, so that we are left with the lower wage "solution," prices fall along with money wages, and either an assumed constant nominal expenditure on output or a real balance effect from a given quantity of money raises real expenditure on output. Still, some of his arguments about why lower real wages generate more employment would apply better to this quite ugly scenario.